A blog of the NYU Colloquium on Market Institutions and the Leipzig Colloquium on the Market Order

Who Said That?

“Economics is not the science that gives accurate near-term forecasts of inflation and output growth. There is no such science.”

What economist said that? Is it the pronouncement of an Austrian, or some other heterodox critic?

Before answering, I want to make a point. In the aftermath of the crisis, economists have been realigning and reassessing their positions. Perhaps the most shocking example (at least to some) is Richard Posner’s breaking with his Chicago colleagues and discovering the brilliance of Keynes and the virtues of regulation (at least in principle).

I have observed a coalescing of views on the Crash of 2008 among Austrians and monetarists. In large part that has occurred because what unites the schools is more than what divides them when it comes to the cause of economic fluctuations. In a 2008 Wall Street Journal interview with Brian Carney, Anna Schwartz reviewed the historical record on asset bubbles or booms. The precise details differ across each boom-and-bust cycle, but in each case “the basic propagator was too-easy monetary policy and too-low interest rates.”

The classic divide in business cycle theory has between real and monetary explanations of cycles. For some years, real explanations have been in vogue. Real business cycle theory is the most notable example. The Bernanke view that a global savings glut caused one-percent interest rates is an example of a real theory. Central bankers are institutionally inclined to non-monetary explanations because they absolve them of responsibility.

At minimum, Austrians and monetarists agree that major economic fluctuations are caused by monetary shocks. The current crisis has caused both groups to push back against trendy real theories of economic fluctuations.

Oh, yes, who said that?

Allan Meltzer in his paper for the 2009 Cato monetary conference: “Learning about Policy from Federal Reserve History.”

“It wasn’t interest rate policy. Many commentators have blamed the Federal Reserve for the financial crisis, claiming that the Fed created a disastrous bubble by keeping interest rates too low for too long. But Canadian interest rates have tracked U.S. rates quite closely, so it seems that low rates aren’t enough by themselves to produce a financial crisis.”

Scott Sumner attacked Anna Schwartz for shifting to a quasi-Austrian perspective, deviating (he claims) from her view in “Monetary History”. Henderson claimed to have been defending monetarism in his pieces (co-written by Hummel) arguing with Selgin over Greenspan’s responsibility.

Speaking of inter-country comparisons, Sumner has attributed Australia‘s lack of recessions to their “looser” monetary policy.

I agree in so far that I do not think it is only interest rates. That would be too easy. There needs to be some kind of optimism for a certain segment and investment decision as well. And leveraging certainly fuelled the bubble. However, central banks did contribute to it by providing the base of money needed for extension. They did not intervene to burst the bubble as the Fed feared a possible recession too much. This was not only attacked by Austrians. Also economists like the well-known Roubini, Ceccetti or Filardo argued that the Fed shall increase interest rates at the right time to prevent bubbles. They did not, so they have to be blamed.

Whatever the merits of the Canadian banking system vis-a-vis that of its Southern neighbor, Krugman failed to point out that Canada, being largely a natural resource-based economy, had lower productivity during the years in question than the U.S. That means the natural rate (whatever it would have been) should have been been relatively lower in Canada, and therefore the spread between the natural rate and the loan rate would have been less there. So even if rates were also “as low” in Canada, they would have triggered relatively fewer overinvestments and malinvestments for a given term structure.

Btw, what’s Canada’s population relative to the U.S.–10% or so? So if they have five banks, what would they have if they had 300M+ people?

“I’ve also been increasingly doubtful that low interest rates ‘by themselves’ are the culprit. Artificially low rates start a fire. accelerant is opportunism, corruption. William Black documents this wrt the S&L crisis. Low rates are a big part of the ‘criminogenic environment’ that government helps establish (my thesis, not Black’s).

Mises himself observed this opportunism during the post-WWI inflation in Austria, but chose to speak only on what he saw as the pure economics of interest rate policy…”

Steele: endogeneous criminal opportunism would be a nice theory, but even without “criminal” what happens shows a basic logic: the safety net reduces the private cost of risk taking, and incentivizes irresponsability; this distortion affects relative prices, spreading false signals throughout the economics system; the combination of perverse incentives and false information provokes systemic fragility in the long run (safety margins are eroded by competition, and competition is fueled by moral hazard, so it doesn’t stop before safety margins are too thin, and then a single black swan is capable of making everything crumble down).

Whatever the source of cost socialization (deposit insurance, countercyclical interest rates, bailout expectations, affordable housing policies), the result is that profit and loss accounting goes astray. Whereas property rights turn a decentralized decisionmaking process into a welfare-maximizing macro-order, these policies amount to creating tragedies of the commons in every market.

Countercyclical credit interventionism amounts to a market process without private responsibility. That a decentralized market system cannot work under these conditions is obvious: the result of this tragedy of the commons is a creeping concentration of power in the hands of the social dictator, as monopoly appears to be an efficient solution to the externalities that make coordination impossible.

1) “Intentionality” is perhaps a better term for what I’m talking about than “criminality.” The credit interventions don’t simply create false signals that confuse entrepreneurs, they create opportunities for a different kind of entrepreneurship, one based on intentional production of toxic assets.

2) I think there’s a systematic tendency for this behavior to occur, but would be hesitant to call it an economic law; the role in any given instance is an empirical question. I’d be interested in knowing of banking and financial crises in which intentional deception by important players didn’t play an important role.

I’m not sure it is a statistically relevant phenomenon. Every crisis shows bankruptcies in excess of normal conditions: some of them are fraudolent. Even if frauds were totally acyclical (a constant fraction of bankruptcies), we would still observe a peak of frauds during the bust. So, I don’t have data to say whether the problem exists or is explained away by adding other variables.

I believe there is some scope for deception of the small investors, but I think that a theory of procyclical frauds should not explain why there is a supply (it’s obvious), but why there is demand. Why does a market for lemons exist? A convincing answer is that there are lots of fools everywhere and everytime, but a microfounded answer would be interesting (for instance, deposit insurance eliminates the incentives for screening, thus enlarging the scope for mischiefs: two persons will not contract efficiently if contracting errors are payed by a third party).